On Central Bank Policies, Asset Inflation, and Inflation Reinforcement

It's been years since I've written a blog post; I've had many ideas but allowed all sorts of other stuff to take priority over writing. If blogs are still a thing, I may become more active now.

In any case, I've been thinking on and off about inflation over the years, what central banks have been doing to try to influence it, especially during the deflationary period in the EU around the time I started investing in 2015, how their policies affect all sorts of prices in addition to consumable goods', including assets', and what basically happens with the fiat money they're supplying economies with. During the last roughly 10 months, rising global producer price inflation and then consumer price inflation have forced me to rethink my investment strategy, and consequently to inform myself on what experts – central bank governors, economics professors, experienced investors and day traders – think about these topics through watching their lectures and interviews, and reading their articles, statements and books.

Since last Tuesday, I've been reading Stephanie Kelton's The Deficit Myth, which explains Modern Monetary Theory to non-economists. While I don't particularly like the way the book is written, especially the way it's playing with readers' emotions in order to convince them of the author's political views, I actually agree with its premise that sovereign currency issuing governments should measure whether they're overspending by looking at inflation rather than budget deficits. I have a lot more to learn about economics before I can answer all the questions I've had for years, but a part of the book has already led me to an epiphany of sorts.

Describing a thought experiment, by some other economist named Eric Lonergan, of the Bank of Japan monetizing 100% of outstanding Japanese Government Bonds, Dr Kelton claims that "transferring all of the outstanding government debt onto the central bank's balance sheet would tend to push prices lower, not higher" – because, as Mr Lonergan had correctly stated, "[the Japanese household sector's] interest income has fallen, their wealth is unchanged, and they are used to falling prices." I think they're on to something, and it might be the answer to why the gargantuan Quantitative Easing programs by all major central banks over the last decade didn't raise inflation when it needed to be raised. In particular, I think what investors would do with a significant sum of cash equivalents newly created by a central bank depends highly on current inflation and could lead to a form of inflation – or deflation – reinforcement different from the regular spirals.

If inflation is relatively high like it is now in the EU, the UK, and the US, and the ECB, BoE, or Fed decide to monetize 100% of outstanding EU, UK, or US government bonds, these bonds' previous holders will find themselves with unchanged wealth, but in a changed form – one that doesn't bear interest – which will mean they'll be losing part of it over time due to inflation. They'll start thinking what else they could do with this wealth, to either protect it or at least use it, now that keeping it in government bonds is no longer an option. In effect, there will be fewer goods, if we include financial assets in the definition of goods, to buy with the same nominal amount of fiat currency. The prices of whatever else the investors decide to buy in place of the liquidated bonds will rise, and this might cause a stock market recovery similar to 2020's, it might cause a real-estate market bubble, or it might cause the prices of goods like cars, and services like education or vacations, to rise. What is common among the different cases is that the existing inflationary environment causes the bond buyouts to cause more inflation in some form.

If inflation is relatively low or even negative like it was during years of QE, Dr Kelton and Mr Lonergan might indeed be right that a liquidation of all government debt might further lower prices. It's generally necessary for investors to keep a portion of their wealth in liquid low-risk assets, and government bonds are just that. However, in a low-inflation environment, cash equivalents like checking accounts can also be that, and lacking any higher-interest alternatives like government bonds or an inflationary pressure to steer clear of cash equivalents, the bonds' previous holders would likely turn to checking, savings, and deposit accounts at banks. They won't invest the currency, so asset prices won't increase. They'll also lose at least part of their interest income, so their disposable income will fall and they'll be likely to buy fewer consumable goods, which will reduce rather than increase consumable prices. Of course, banks could hypothetically invest the money so deposited with them, but I think some similar logic applies to them, because in the low-inflation environment we were seeing their reserves increase. So, in effect, the existing low-inflation environment causes the bond buyouts to lower inflation further.

While QE is not an actual monetization of government debt, I think it does create similar conditions by firstly increasing the money supply and therefore free cash equivalents, and secondly increasing bond prices and lowering their yields to around zero, thus incentivizing private investors to sell them. What this seems to suggest is that QE cannot be an effective policy for influencing inflation, because it only reinforces current trends, rather than reversing them. In that case, maybe its opposite, Quantitative Tightening, can reverse them. Who has any thoughts on this?

Another interesting question is what happens with the currency that was created through QE during a low-inflation environment after the inflation then increases. My hypothesis is that at present, the parts that went into stocks and properties are still there, as their market capitalizations don't seem to have crashed significantly yet, or at least there hasn't been a significant net outflow of cash from markets. In late March, US stock market total market cap as % of GDP was still above pre-pandemic levels. On the other hand, the parts kept in lower-risk assets might have started fueling inflation as investors try to minimize their real losses caused by it through selling assets with negative real returns and using the currency thus freed for consumption. Some of it might also be flowing into the stocks and properties markets and delaying their crashes. I don't know where to find the relevant data yet, but if I keep my interest in the topic, I'll probably try to find it and maybe even build a model that explains the past few years.

Update, 1 year and 4 months later: I have not built a model or even found the relevant data, but I have kept my interest in the topic at least enough to keep on learning about it. Recently, I listened to an interview published shortly after this blog post, in which prof. John Cochrane explains the fiscal theory of the price level. I'm planning to read his book on it soon-ish in order to understand more, but from what I gathered from the interview, it has very similar assumptions to MMT (e.g. that the value of fiat currencies comes from them being legal tender, that price inflation is not a monetary phenomenon per se, that high interest rates actually have to be inflationary in the long term) and yet reaches seemingly opposite conclusions (that governments issuing sovereign currencies do still need to worry about structural budget deficits) and is supported by economists with quite different political views (libertarians, rather than leftists). Perhaps the conclusions are opposite only at first glance, and in fact reflect the same reality (structural budget deficits lead to inflation, which is MMT's sign that government spending should be reduced and taxes increased, i.e. that the budget deficits should be reduced), and it could even turn out that FTPL is MMT with added calculations :D. I'll definitely need to explore more.